Tax Cuts

As long as I can remember, the mantra of the Republican party has been that “reducing taxes stimulates the economy”.  Is that really true? Let’s take a close look at that. To examine that we need to look at who benefits from the tax cuts, how is the money from the increased profits used, and how does the economy respond.

So, who benefits from the tax cuts?  Comparing tax rates today with those in 1952 using official I.R.S. tax guides, a 1%er couple earning about $3M filing jointly would pay about $1.1M in taxes compared to $2.4M at 1952 tax rates, a savings of $1.3M.  A middle class couple earning $55,000 would pay about $5,400 compared to $10,700 at 1952 tax rates, a savings of $5,300. Thus the 1%er received a tax break of $1,300,000 compared to the $5,300 tax break for the middle class couple.  And this does not include capital gains and carried interest that are taxed at a maximum of 15% and neither of which benefit the middle class. Clearly, the 1%ers come out well ahead in the game.

Do tax cuts stimulate the economy?  That depends on the state of the economy and the distribution of income of consumers.  There is no incentive for an investor who receives a windfall profit from a tax cut to invest in productive capital (i.e., factories, shops, services that add workers to the labor force thus stimulating the economy) if consumers haven’t the discretionary income to purchase goods and services beyond those necessary for basic living. When that is the case, the alternative is for the investor to invest in financial instruments, i.e., stocks, bonds, derivatives, etc. (paper capital that does not stimulate the economy). So the necessary condition for economic growth is a large number of consumers with sufficient discretionary income to afford to purchase the goods and services offered.

So where are we today?  With a declining middle class, the average consumer has less discretionary income and is able to afford less. Thus demand is falling and as that trend continues, investors will invest in paper capital rather than productive capital, and this doesn’t stimulate the economy.

In the 1950’s and 60’s, the tax cuts did stimulate the economy because there was a robust middle class with sufficient discretionary income to create a large demand for goods and services and investors responded by investing in productive capital.

The bottom line is that given our disappearing middle class, demand will continue to fall and incentive to invest in productive capital will fall with it.  Instead stimulating the economy, tax cuts that primarily benefit the 1%ers will only increase their wealth at the expense of the middle class and accelerate their decline.  This, in turn, will lead to further reductions in demand and overall economic decline.